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Morningstar | Strong Execution at Guidewire Facilitates 2Q Beat; Maintaining FVE

Guidewire reported a stellar fiscal second quarter, exceeding guidance as well as consensus expectations on both the top and bottom lines. Though the adoption of ASC 606 continues to somewhat obfuscate year-over-year comparisons, the firm’s continued execution remains apparent, allowing management to narrow and increase their revenue and adjusted EPS guidance, respectively. Guidewire’s ability to facilitate operational efficiency and data integrity remains mission-critical, particularly in the volatile P&C insurance industry, where the execution of mundane processes is crucial to competitive differentiation. We view these industry dynamics as largely immutable, and consequently believe that the firm will be able to leverage its incumbency to remain germane among its customer base for the foreseeable future. Thus, we will maintain our wide moat rating, as well as our fair value estimate of $114 per share. Even after trading sharply higher after hours, the shares continue to offer a margin of safety relative to our estimate of intrinsic value, and we still view current levels as exceedingly compelling.

Revenue came in at $169.3 million, representing year-over-year growth of over 3%, with license and subscription revenue growing at a similar rate to the total. Adjusted operating margin was 15.4% which, though above guidance, represented a 420 basis point year-over-year compression as cloud and service sales continue to weigh on margins. Structural margin headwinds, such as infrastructure costs for cloud deployment, are being exacerbated by management’s decision to offer lower price points for subscriptions and implementation in order to make transitions less economically cumbersome for customers. Management expects positive NPVs over the longer term as the concessions are offset by higher customer lifetime value. We fully agree with this sentiment, particularly given the switching costs that support the firm’s competitive positioning.

Guidewire now expects fiscal 2019 revenue to be in the range of $725-$732 million, versus a range of $722-$732 million previously. The firm saw strong subscription momentum in the quarter, with these deals representing 53% of new sales, reflecting continued secular demand shifts. Enterprises, including P&C insurers, are increasingly wanting IT applications across the software stack to be services delivered reliably and flexibly, in lieu of static tools that require hardware provisioning and maintenance.

We remain confident in the firm’s ability to maintain its footprint as well as deepen existing relationships across multiple touchpoints with their cloud platform. Guidewire consummated its first InsuranceSuite cloud deal of the fiscal year with TD Insurance, a subsidiary of TD Bank. Additionally, we were pleased to hear that management was able to expand relationships with 26 existing customers, primarily by fostering adoption of digital offerings. The firm has now managed to cross-sell roughly a third of its customer base with a digital product, and we believe these offerings, in conjunction with other nascent analytics products, will only serve to increase the stickiness of the platform and generate upside to our base-case revenue assumptions.

Finally, though the firm has regained some momentum with their cloud negotiations, the timing of deals in the pipeline remains highly uncertain. This is evidenced by the still-lower revenue guidance compared with two quarters ago, when management assumed that a large portion of these deals would close during the current fiscal year. We reiterate that, in our view, the delays, and more importantly the byzantine negotiations surrounding various system requirements and security protocols, lend credence to our thesis on Guidewire’s structural advantages. The multiple steps involved before these solutions can be deployed in earnest speak to high switching costs, and the confluence of these switching costs with Guidewire’s incumbency as a leading P&C insurance platform undergird our wide moat rating.